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Investor herding instinct

`Institutions are herding animals. We watch the same indicators and listen to the same prognostications. Like lemmings, we tend to move in the same direction at the same time. And that, naturally, exacerbates price movements’. [Wall Street Journal (October 17, 1989)]

As long-term investors, we should expect pension funds to focus on their long-term investment strategy. Pension funds also have predictable cash outflows and hence are unlikely to face substantial unanticipated short-term liquidity needs. They are therefore in a position to provide liquidity to financial markets at times when it is needed, for example, by investing in illiquid assets during financial crises, thereby helping stabilise financial markets and earning a liquidity premium in return.

However, pension fund managers tend to have similar benchmarks. This, in turn, might create a fear of relative underperformance compared with the peer group of fund managers and hence an incentive for them to herd, that is, to buy and sell the same asset at the same time; this type of herding is often termed “reputational” herding. If pension fund herding results in procyclical or positive-feedback investment strategies – buying assets in a rising market, selling in a falling market – this could have a destabilising effect on financial markets.

Our study – The market for lemmings: Is the investment behaviour of pension funds stabilising or destabilising?* – examines whether pension funds herd in and out of different asset classes. It also investigates whether herding is more predominant in subgroups, consistent with reputational herding. We classify pension funds into subgroups according to their size and sponsor type. Our analysis is based on a unique data set provided to us by State Street Investment Analytics, covering one third (by value) of UK pension funds’ asset holdings. The data covers UK private-sector and public-sector defined benefit pension funds’ monthly asset allocations over the past 25 years.

Our evidence provides support for the hypothesis that pension funds herd together in the very short term. There are a number of possible reasons for this. In addition to reputational herding, there is habit investing and momentum (that is, positive feedback) trading. Our evidence comes down in favour of reputational herding, since we show that pension funds herd in subgroups. We double sort funds by sponsor type (private-sector and public-sector) and by size (small, medium and large). We find that public sector funds follow other public sector funds of similar size. Similarly, large private sector funds strongly follow other large private sector funds.This could clearly be destabilizing if pension funds were also to follow the same positive-feedback strategies, such as momentum trading.

Our findings also indicate a strong short-term portfolio rebalancing by pension funds if short-term valuation changes drive the weights away from the asset mix specified in their investment mandate. Further, although we do not have any data on the pension funds’ liabilities, we can draw inferences about the changing maturity of their liabilities from the longer term dynamic asset allocation strategies pursued by the pension funds over the course of the sample period. The average pension fund – as represented by the peer-group benchmark – appears to rebalance its long-run portfolio in a way that is liability matching. As the maturity of pension fund liabilities has increased, large private-sector pension funds, in particular, have systematically switched from UK equities to conventional and index-linked bonds.